Professional Documents
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Finance
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An easy question
• Q. Which would you rather have: $100 today or $100 ten years later?
• A. That’s easy. You want it today.
• Lesson: Money today is more valuable than the same amount of
money in the future.
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A harder question
• Which would you rather have: $100 today or $150 two years later?
• Should you take the second option just because 150 is more than 100?
• Why?
• You need some way to compare sums of money from different points in
time.
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Present Value
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Future Value
• Suppose you know that $5.00 will become $8.15 after 10 years.
• That is, $5.00 is the present value of $8.15 received 10 years later
• If you had to choose between $5.00 today and $8.15 10 years later,
which would you choose?
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Choices I
• Cem states that getting $8.15 ten years later is better than getting
$5.00 today.
• Had he instead taken $5.00 today, he could’ve put it in a bank. In
that case, 10 years later he would’ve had the same $8.15
• Therefore, for him, choosing to receive $8.15 ten years later is
equally attractive as choosing to receive $5.00, the present value of
$8.15 today!
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Choices II
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• Which is better: $7 ten years later or $5.00 today?
• Answer: $5.00 today
• Which is better: $8.15 ten years later or $5.50 today?
• Answer: $5.50 today
• Which is better: $8.15 ten years later or $4.50 today?
• Answer: $8.15 ten years later
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Using present value to make choices
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Choices and present value: examples
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• Clearly, $210 is best.
• Therefore, you should choose to receive $659.12
after 12 years
• This is the option that has the highest present value
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Decimal notation of interest rate
• Suppose people can freely lend and/or borrow at the interest rate of
5%.
• Recall that “5 percent” is “5 out of 100” or 5/100 = 0.05.
• The decimal form of 5% is 0.05.
• We will use the symbol r to denote the interest rate in decimal form.
• If the interest rate is 5%, we will write r = 0.05.
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Compounding: One year
• If r = 0.05, then $200 deposited in a bank today will grow in one year
to:
• The original amount (or, principal) of $200, plus
• The interest earned, which is 0.05 × 200 = $10.
• That is, if r = 0.05, then $200 will grow in one year to 200 + 0.05 ×
200 = (1 + 0.05) × 200 = $210
• Suppose this amount is immediately reinvested for yet another year.
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Compounding: Two years
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Compounding
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Future Value Formula
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Present Value Formula
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Future value and present value
• To repeat,
• If we know P, the present value, we can calculate its future value as F = (1 +
r)N × P.
• And if we know F, the future value, we can calculate its present value as P = F
/ (1 + r)N .
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Examples: future values and present values
• If the interest rate is r = 0.10 (or 10%), the future value of $200 after
8 years can be calculated as
• F = (1 + r)N × P = (1.10)8 × 200 = $428.72
• If the interest rate is r = 0.08 (or 8%), the present value of $500 to be
received after 10 years can be calculated as
• P = F / (1 + r)N = 500/(1.08)10 = $231.60
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Choice
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Choice: investments
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Present value and the interest rate
Utility loss
from losing
$1,000
0 Wealth
Current
$1,000 wealth $1,000
loss gain
The Markets for Insurance
• Market risk is the risk that affects all economic actors at once
• This is the uncertainty associated with the entire economy.
• Diversification cannot remove market risk.
Figure 2 Diversification
Risk (standard
deviation of 1. Increasing the number of stocks
portfolio return) in a portfolio reduces firm-specific
(More risk) risk through diversification…
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2. …but
market risk
20 remains.
(Less risk)
0 1 4 6 8 10 20 30 40 Number of
Stocks in
BASIC TOOLS OF FINANCE Portfolio 46
Market Risk and the Rate of Return
3.1
0 5 10 15 20 Risk
(standard
deviation)
Which Stocks?
• Now that you have decided how many stocks to buy and how much
of your wealth to spend on stocks, how will you decide which stocks
to buy?
• The efficient markets hypothesis is the theory that asset prices reflect
all publicly available information about the value of an asset.
Efficient Markets Hypothesis